Construction Fever

Aug 10, 2020

Lockdown seems to have Americans re-evaluating their living situations as houses fly off the market. Record low mortgage rates and scarce inventory may factor into why US home construction rose 17.3 percent in June 2020. Are you thinking about breaking ground? Be sure to understand your financing options.

How Do Construction Loans Work?

A construction loan is a loan that covers the period in which a home is built. The future homeowner borrows a lump amount that the lender releases to the contractor in waves. While the house is being built, the borrower makes interest-only payments on the contractor's amount dispersed. Unlike a traditional mortgage, there is no collateral against the loan since the home is still under construction. This causes interest rates on construction loans to be higher than what's available for similarly sized mortgages.

What's Next?

Upon completion of the build, what happens next is determined by the kind of construction loan you have. There are two main types of construction loans. The first is a construction-to-permanent loan, where the outstanding balance is converted into a traditional mortgage when the home is move-in ready. The upside to this type of loan is that you only pay closing costs once.

The other type of loan is a plain construction loan, meaning the balance is due upon completion of the home. Typically, a borrower will take out a traditional mortgage to pay off the construction loan, thus applying for and closing on two separate loans. The attractive feature of this kind of loan is that borrowers can shop for the best rate when securing the new mortgage.

Uh-Oh!

There are a few financial risks to keep in mind when taking out a construction loan. It's not unheard of for a project to go over budget. Depending on local comps, the finished home may not appraise for what you've borrowed. Both scenarios create unexpected costs.Consider how you might address these problems.

  • Do you have the excess cash on hand?

  • Will your lender allow you to add it to the loan principal?

  • Can you secure additional financing?

Conclusion

The idea of having a say in every little detail of a brand new home sounds appealing. Be sure to weigh your financing options and consider the risks before breaking ground!

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